When Does A Cryptocurrency Bubble Burst?

A stock market bubble bursts when companies go bust. A real estate bubble bursts when people can’t pay their loans and homes are foreclosed. So when does a cryptocurrency bubble burst?

Let’s talk Bitcoin for now, and get the obvious out of the way. The price is decided by the market, by supply and demand. Supply is somewhat capped. Currently demand is largely being driven by two somewhat related concepts: speculation, and fear of missing out. But there are other, more concrete factors affecting demand - this is critical, and frequently overlooked.

If Bitcoin was a company, where would it's value derive from? People tend to immediately mention the underlying technology which enables a wealth of applications, but which many competing cryptocurrencies and blockchains provide. Arguably, some other currencies and blockchains are technologically superior, in ways which improve their use as a currency or store of value. But technology isn’t everything - it does not take long to develop a Facebook clone, or a Bitcoin clone for that matter.

Use as a currency

Bitcoin’s application as a currency contributes to demand theoretically - people wanting to buy with Bitcoin will need to acquire some first, increasing demand. However the effect this has on Bitcoin’s price becomes very clear when you consider that, for example, BitPay’s payments volume grew by 328% in 2017, on track for $1 billion yearly.

People frequently assume Bitcoin payments are just made by enthusiasts, but for certain use cases, Bitcoin is a highly competitive payment method. Bitcoin payments can clear in an hour or two, compared to an entire business day for a wire transfer, or 1-3 business days for international transfer. PayPal charges a 2.9% fee to receive payments, but BitPay charges just 1%. These and other cases demonstrate where the realities of Bitcoin payments are materially better than its competitors.

Brand

But why Bitcoin and not a competing cryptocurrency? Much of Bitcoin’s value comes from its brand, certainly, which currently afford it incredible media coverage, rivalling the most important companies in the world (hence the fight with other cryptocurrencies over the name). No mainstream article on cryptocurrency fails to mention Bitcoin, and it is the most well known coin by a wide margin.

Network effect

The more retail outlets that accept Bitcoin, the more consumers will hold Bitcoin, which will encourage more outlets to accept Bitcoin, creating a powerful feedback cycle. And it’s not just retailers that count here, it’s also exchanges, companies that provide cards people can use at the point of sale, and the whole ecosystem around it. Like all technologies supported by network effects (think Myspace being killed by Facebook and failing to be killed by Google+) it takes a much more superior product to supplant it.

Innovation

The fact that Bitcoin is the preeminent cryptocurrency means that the vast majority of attention in the space is focused on it. As a result it’s where most investment money pours in to companies building on the ecosystem, and it’s where most innovation and development occur. Compared to other cryptocurrencies it has the strongest development team. The enormous amount of people and businesses who own Bitcoin means there’s an enormous amount of people invested in ensuring its success.

You may have heard that recently Bitcoin is becoming less viable for payments and given that much of it's value derives from this fact, we may reasonably be concerned. This issue is being tackled by the lightning network, an example of the amazing levels of innovative development occurring in the space. For those new to Lightning, it promises instant, low-cost transactions.

Speculation

When something offers the possibility of 1000% gains, it becomes a tantalising prospect for everyone, not just true believers. People are gambling on the possibility of extracting similar gains, against the risk of losing their investment. But the scale of interest is mind-boggling. Bitcoin’s gone from being on the fringe of society to near-daily articles in publications like Forbes (Just look at the title of that article!), Bloomberg, CNBC - every notable financial and news publication is devoting a huge amount of real estate to Bitcoin, and the reason is, why else? Because legions of readers want in on the action.

This is just getting started. Futures have only just launched, dramatically increasing the likelihood of an ETF launching. One can imagine that once owning Bitcoin is as easy as owning a stock, that we’ll see an even bigger upswing as the fear of missing out compels even more every day investors to allocate more of their high risk investing to Bitcoin.

So when does the demand from speculation stop? Somewhat by definition, when people stop believing the price will rise. Or as a friend recently put it, when expectations meet reality. Of course no one knows what will trigger a crash, as all it takes is sufficient negative sentiment. This means it can strike at any time. But as we’ve seen, Bitcoin has fundamentals just like any company, which means the coin has intrinsic value. We know the supply, so the price just depends on demand. And these fundamentals cause the demand.

Crash triggers

Government intervention is most frequently mentioned as a risk. We’ve seen some countries move to regulate bitcoin, and subsequent downward pressure on prices. In the United States however, we’re seeing mainstream financial industry acceptance greatly accelerating, and the current administration isn’t exactly known as a heavy-handed regulator.

Other frequently mentioned risks are disruption by a sufficiently superior competitor, a sizable technological fault or circumvention of the encryption technology, or a massive exchange hack or failure. Coinbase going down would be pretty apocalyptic for bitcoin, but this has happened before with Mt. Gox. It just takes another exchange (of which there are many) to step into the spotlight.

While these are all possibilities, it's hard to see dragons given the longevity of bitcoin, its endurance against multiple such scandals, and the fact that billions upon billions hinge upon its security and have been safe for years.

The value

Bitcoin’s true value is in its use as a currency and store of value, but particularly in its wide acceptance and massive ecosystem of supporting products and services. Its preeminence in the cryptocurrency world, and increasingly in the mainstream financial world drives massive amounts of goodwill and investor interest. These are the fundamentals that drive bitcoin, and even amongst the most important companies and commodities, they are exceptional.